Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Giant Interactive Group Inc. (NYSE:GA)

Q3 2007 Earnings Call

November 20, 2007 8:00 am ET

Executives

Yuzhu Shi - Chairman of the Board of Directors, Chief Executive Officer

Wei Liu - President, Director

Eric He - Chief Financial Officer

Analysts

Eddie Leung - Merrill Lynch

Benjamin Schachter - UBS

Ken Kim - Merrill Lynch

C. Ming Zhao - Susquehanna

Jerry Sullivan - American Century

George Chu - UBS

Alicia Yapp - Citigroup

Defan Jian - City Capital Assets Management

Charles Ho - CAVA Capital

Presentation

Operator

Welcome to the Giant Interactive Group Incorporated third quarter 2007 results conference call. Before we continue, I would like to remind you that all statements on this call that are not strictly historical in nature constitute forward-looking statements. Such statements include, but are not limited to, statements about the development of ZT online expansion pack, ZT online PTP and Giant online, and King of Kings 3, and our anticipated results of operation. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results of Giant to be materially different from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, risks and uncertainties related to the progress, timing, cost and results of game testing and product development competition from the other online game companies, and the additional risks discussed in the filings with the Securities and Exchange Commission. All forward-looking statements are qualified in the entity by cautionary statements and Giant undertakes no obligation to revise or update this information to reflect events or circumstances after the date hereof.

I would like to now turn the call over to your host for today, Mr. Eric He, Chief Financial Officer of Giant Interactive Group. Please go ahead, sir.

Eric He

Thank you, Operator and good morning, everyone. Thank you for joining us for our third quarter 2007 results conference call, our first as a public company. Joining me today are Mr. Yuzhu Shi, Giant Chairman and CEO; and Ms. Wei Liu, our President. As we proceed through our prepared remarks, we will refer to our result presentation, which can be downloaded from our website at www.giantig.com. Following the remarks, Mr. Yuzhu Shi, Ms. Liu and I will be happy to take your questions.

2007 has been an exciting year for Giant, marked by a number of key milestones; most importantly, our IPO and NYSE listing on November 1, 2007. A brief overview, which is provided on slide 4, our listing was a milestone event on a number of fronts, as we were the largest IPO from a Chinese entrepreneurial company to have gone public in 2007 and the first Internet online game company from China to list on the NYSE.

Before moving to the results for the quarter, let me begin with a brief overview of Giant, starting on slide 5, for the benefit of those of you that may be new to our company.

We are a leading developer and operator of online games in China, focusing on MMORPGs and creator of ZT Online, China’s most popular game as voted by players in 2006, according to a report published by IDC.

We have witnessed strong growth since the launch of ZT Online, which reached over 1 million peak concurrent users in the second quarter of 2007 and has net revenue growth of 164% year over year for the third quarter of 2007.

Driving this growth has been our passion for games, which is a key component of our corporate culture and fuel of strong product development and technological capabilities. Together with our extensive marketing and distribution infrastructures and deep understanding of Chinese mass markets, we have established a strong base for the development of future games.

Let’s now look at some of the key operational developments from the quarter, starting on slide 6. ZT Online is currently our primary revenue driver and continued to achieve strong growth and acclaim since its launch in 2006. That said, our third quarter 2007 ACU and PCU have declined slightly on a sequential basis, as we institute a change in our game rule to discourage gold farming activities in June 2007.

However, in an effort to maintain ZT Online’s leadership position in the market, we continue to release new content and features into our games. As part of this effort, we launched ZT Online’s fourth expansion pack in July 2007 and as a result, we believe that our player interactivity options will greatly enhance within the game, as well as player loyalties to the game. In addition, we have witnessed improving ACU and PCU figures each month during the third quarter of 2007.

We believe that as a result of the market acceptance of this expansion pack, and as noted on slide 7, we saw an 88% year over year increase and a 3.3% sequential growth of active paying accounts, or APA, from the second quarter of 2007, resulting in a 1.3 million APA for the third quarter 2007.

Our APA increased every quarter in the last seven quarters since ZT Online’s commercial launch. In addition, ARPU shows strong growth, increasing 38% over the third quarter 2006 and 5.6% sequentially quarter over quarter to RMB305, approximately $41.

As noted on slide 8, the next expansion pack for ZT Online is slated to be launched toward the end of the fourth quarter. This expansion pack is expected to greatly enhance the geographical and dimensional interactive experience of our players.

Another addition to our product portfolio is ZT Online PTP version, in which players are able to purchase playing time but not virtual items. We currently launched ZT Online PTP and we believe this new offering will likely capture a niche market and will deepen our market penetration. So far, we are making good progress.

Giant Online is our highly anticipated new game with over 150,000 daily volunteer playing players currently having participated in the closed beta testing, which reached over 30,000 concurrent users. Giant Online has already been commercially launched in the fourth quarter of 2007 and the responses thus far have been very positive. We anticipate to start ramping up users by the first quarter of 2008.

Looking farther out, we expect to launch King of Kings 3, a free-to-play fully 3D MMORPG in the second quarter of 2008.

As shown on slide 9, a key component of our growth strategy is our distribution and marketing efforts aimed at expanding our reach beyond the major metropolitan centers and larger cities, and into the under-penetrated medium and smaller cities.

Several macro trends also noted on slide 9, including increasing urbanization, household income, as well as limited entertainment options in these regions provide us with the opportunity to tap into a large player base that is willing and able to pay and display a high level of player loyalty. These characters will translate into huge market potential.

To reach this large untapped market segment, we have been busy expanding our nationwide marketing and distribution network, highlighted on slide 10. As part of this expansion in the third quarter, we added an additional 1,200 sales liaison personnel, bringing our total to 3,500 as of October 1, 2007.

In addition, we added 220 new liaison offices during the third quarter, so now we have over 470 liaison offices as of September 30, 2007. Our goal is to maximize player awareness and recognition of our games, which in turn resulted in greater market penetration.

Now, let’s move on to an overview of our financial results for the quarter. I will provide a summary of key financial highlights for the third quarter and the nine months ended September 30, 2007. A summary of these results can be found on the slide 12 to 15 of our presentation.

On slide 12, you can see both our top and bottom line highlights. Year over year, total net revenue were up over 164% to RMB405.2 million, or $54.1 million. This increase is mainly attributable to an increase in online game net revenues, which grew more than 163% to RMB404 million, or $53.9 million. ZT Online has maintained a solid customer base, largely due to our continual product enhancement efforts, resulting in a solid quarter after quarter revenue growth.

Net income was up over 152% year over year to $290.2 million, or $38.7 million.

We are also pleased to report an increase in gross profit, which grew more than 153% to RMB359.8 million, or $48 million, over third quarter 2006.

Our margins remained very strong, as you can see on slide 13. Gross margin decreased slightly due to our increased investment to develop our infrastructure in preparation for the launch of our new games and expansion packs.

On slide 14, you can see that our operating expenses for the quarter totaled RMB70.2 million, or $9.4 million. Included in our total operating expenses were RMB7.2 million in R&D expenses that went toward hiring new employees to aid in the development process of our new games.

RMB59.6 million in sales and marketing expenses which were used to help expand our marketing campaign throughout almost every province of China, including an increased focus on the medium and smaller cities, and RMB20.1 million in general and administrative expenses.

As we continue to grow and expand our business, we are making a conscious effort to control costs and optimize our efficiencies. We have no income tax expenses to report for this quarter as we are currently still experiencing a tax holiday.

Cash and cash equivalents at the end of the third quarter totaled RMB1.171 billion or $156.1 million. We currently have a sizable cash balance of approximately RMB6.8 billion, or $905 million, including proceeds generated from our IPO, which we intend to use towards the continual growth of our business, including financing capital expenditures and funding of future acquisitions to further accelerate our growth.

With our established track record, focused strategy and solid operational foundations, we are confident in our ability to realize our goal of becoming the largest online game developer and operator in Asia.

Thank you for your time. We are happy to take your questions. Operator, please begin the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Eddie Leung, Merrill Lynch. Please proceed.

Eddie Leung - Merrill Lynch

Good evening. Good quarter. I have a couple of questions. The first question is could you elaborate a little bit more on the trend of your ACU and PCU throughout the third quarter, as well as if you [made a chart] about some of the initial trends that we see in the fourth quarter to address some of the concerns from some people.

Number two, could you also talk a little bit about the feedback that you get from users during the closed beta testing for your new game, Giant? Thank you.

Eric He

Thank you, Eddie. I will direct this question to Ms. Liu, our President. Ms. Liu, please.

Wei Liu (Translation)

Eddie, I will address your first question first, in terms of the trend of the ACU and PCU in our third quarter. As we know, in the second quarter ’07 our ACU and PCU numbers actually reached a high point. In the third quarter, the beginning of the third quarter, we are seeing a slight dip in terms of these two numbers. The reason is really because we introduced a change in one of the game rules to discourage gold farming activities we are seeing and that actually caused the ACU and PCU number to dip. However, we believe the change is beneficial in terms of the company’s long-term growth.

In July, we actually released the expansion pack. It’s called Zhong Zhi Cheng Cheng. We are happy to witness an improving ACU and PCU number. Up until now, our PCU number has come back up until about 900,000 concurrent users.

In addition, I would like to point out two other very key parameters. One is called active player players, APP. We are seeing the continuous improvement in this number. In the third quarter, this number actually has reached up to 1.3 million users and that represents approximately 5.6% of increase compared to last quarter.

The second important parameter is of course the ARPU value and we are seeing in the third quarter this number actually increased for more than 3%, about 3.3% compared to the second quarter.

Eric He

Now I would like to direct the second part of the question to Mr. Shi, the feedback on the preliminary feedback on Giant Online.

Yuzhu Shi (Translation)

To address the second question in terms of the feedback coming out from the closed beta testing of Giant Online, I think so far we have been receiving very positive feedback from those testers.

Currently we are undergoing this dual closed beta testing. We expect to start the official closed beta testing beginning next month. Even though currently we don’t view ACU/PCU parameters as sort of key indicators of whether the game is going to be successful or not just yet, we are happy to see more than 400,000 concurrent users in the game already and also, we’ve actually seen volunteers reaching up to 150,000 concurrent users. So far, the feedback from all those users has been very positive.

So far we have managed to build in a few dozen, more than a few dozen innovations into the game and we believe with the continuous introduction of more innovative ideas and rules or functions, we will receive better feedback from the user.

Starting in next quarter, we’ll start open beta testing and with that, we expect to have put in more resources in terms of launching and experimenting the game and until then, we will expect to have much more user base or much more feedback coming out from this pool.

Compared to the initial feedback, the closed beta testing feedback from this user pool from Giant Online compared to that feedback we got from ZT Online, we actually have seen a much better feedback from the user.

Eric He

Next question, please.

Eddie Leung - Merrill Lynch

Yes, thank you, Eric. (Translation not available) Thanks.

Operator

Your next question comes from the line of Ben Schachter from UBS Securities. Please proceed.

Benjamin Schachter - UBS

Good evening and congratulations on your first quarter as a public company. First question, I was just wondering if you could talk about, should we expect any revenues in 4Q from Giant Online or ZT PTP?

The second question, I was wondering if you could just clarify what the line item in the expenses under government incentives, what that represents.

And then finally, I was wondering if you have any comments on concentration of revenues around the top 20% and the top 5%, if that’s a number you can give us and where we should expect that to go over time. Thanks.

Eric He

Sure. Let me answer your questions. As we said it in the prospectus, Giant Online and ZT Online PTP both are actually commercial launch in this quarter, meaning that we start collecting revenue for those two games. However, their contribution, their revenue contribution in the fourth quarter of this year is very minimal, because as you know, we just introduced a game to the public and also because accounting principles can recognize very little, a small percentage of the revenue.

The second question is regarding the government incentive. That government incentive in fact is a refund of our business tax. That business tax actually was and has been a deduction of our revenue, meaning that it’s been put in as a cost of services. So on a recurrent basis, every third quarter of the year, we will receive a refund of government refunds on that business tax. So it happens in the third quarter of ’06 and it also happened in the third quarter of ’07, so according to accounting principles, we will have to include that into our operating expenses, the deduction of operating expenses. So that is the nature of the government incentive.

The third one is the revenue. The revenue concentration, actually we haven’t seen too much differences. As we mentioned before, the top 5% of the -- the top 20% of the paying accounts account for 80% of the revenue and the top 5% accounts for about 50% of the total revenue. I think that revenue mix is still pretty much hold true for the third quarter, so we haven’t seen too much of changes in that mix yet.

Benjamin Schachter - UBS

And then the final question is ARPU into 4Q, should we expect that to go up or down?

Eric He

Ben, that’s a tough question. As you know, ARPU is a combination of revenue and active paying accounts, or active paying users. Now it’s in the middle of the fourth quarter. It will be very difficult for us to forecast what is the final result of ARPU in the fourth quarter. All we can say is, as Ms. Liu mentioned, that our ACU number actually has been progressing very well and the feedback from Giant Online has been very positive, so management is very confident on the outlook of the business and the company. So I think an ARPU number, I cannot answer the question for the time being at this moment, but we are very confident on the prospect of the company and the business.

Benjamin Schachter - UBS

Thank you very much and congratulations again on your first quarter as a public company.

Operator

Your next question comes from the line of [Ken Kim], Merrill Lynch. Please proceed.

Ken Kim - Merrill Lynch

Great first quarter. I just had a couple of questions with regard to first of all, the number of servers you now currently have for ZT. And you talk on page eight about Giant Online and the advanced server technology that’s going to enable up to 1 million concurrent users. How many of those servers have you already prepared and what should we expect in terms of a rollout for the number of servers per quarter?

And then the second question would be there’s talk of your Giant Online potentially having a price cap. Obviously there’s some worries with regard to -- that this game might cost a lot of money for the user. Could you tell me if that’s just a false rumor out in the market, or you are considering during the beta testing of somehow limiting the amount of money spent by a user? Thank you.

Eric He

Okay, very good. Let me handle the first question and then I will pass the second question to Ms. Liu, our President, to talk about in terms of the Giant Online question. Let me just translate the second part, and then I’ll answer the first part.

Let me answer the first question. In terms of servers, for ZT Online, as you know it’s a huge mega-game. We actually have more than 1,700 servers around the country to service our customers. Our goal is to provide a state-of-the-art service to our users, so we constantly are adding or replacing our servers along the way.

As to your question regarding the Giant Online, the server technology, yes, we have a very unique server technology which will allow more than 1 million players playing in a single shot and we are actually ramping up that server farms at this moment. It’s a clustering structures for the time being because as you can tell, the participants right now, it’s about 150,000 and the concurrent user is in 30,000 to 40,000, so the number compared with ZT Online still is not up to that scale.

At this moment, we are ramping up the servers for the time being. The percentage, the servers servicing the Giant Online, the percentage is not very high. I would say it’s only 5% to 10% of the 1,700 servers as compared to the ZT that is currently in use.

Now I would like to refer the second question to Mr. Shi. Thanks.

Yuzhu Shi (Translation)

First of all, I just want to highlight that there is some difference in terms of Giant Online and ZT Online. ZT Online actually focuses a lot about establishing a hero or leadership in the game. It’s more about individualism, while with Giant Online, we are promoting the teamwork spirit.

So in order to encourage the teamwork spirit, we purposely built in the rule to limit each individual’s capability by implementing such a rule, i.e. putting a price cap in terms of how much they can spend in the game.

In ZT Online, we are seeing 15% of people are paying users or paying players, while 85% of remaining users are non-paying players. In the closed beta testing phase of Giant Online, there is a much higher percentage in terms of the paying players at a slightly lower ARPU value.

From current assessment, we believe that the average income or the revenue from Giant Online will not be lower compared to ZT Online.

Eric He

Did we answer your question?

Ken Kim - Merrill Lynch

Yes.

Eric He

Okay, good. Next question, please.

Operator

Your next question comes from the line of Ming Zhao from SIG. Please proceed.

C. Ming Zhao - Susquehanna

Thank you. Good evening. Congratulations on your recent IPO. (Translation not available) So my first question is what have you done internally and externally after your IPO?

Wei Liu (Translation)

The answer is yes, we have done quite a few work both internally and externally. The first thing we did is we organized a town hall meeting, whereby we organized everybody to come in and remind them we are still a young company and also we need to stay entrepreneurial. We actually have set new targets in terms of performance for both ZT Online and Giant Online for every employee, so all the team members, we know that we need to stay focused and work together as a team towards the new goal.

Secondly, we actually formed a strategic development group or department whereby this core group of people, their responsibility is to keep identifying the earlier stage R&D, new ideas, innovations, and also M&A opportunities and strategic alliance opportunities.

Thirdly, in terms of licensing, we are actually engaging in active dialog for discussions with overseas established players in this space to seek further collaboration opportunities.

C. Ming Zhao - Susquehanna

(Translation not available) My second question is what is the reason for licensing King of Kings 3? Thank you.

Yuzhu Shi (Translation)

First of all, I think one thing to correct is in terms of King of Kings 1, the first game, we think it was a great game. It was very well-known and quite popular, frankly speaking, in China at that time.

We admit that for King of Kings 2, it actually experienced very limited success. Part of the reason we are seeing, possibly due to the change of development team members. In terms of King of Kings 3, this game was essentially developed or conceptualized by the same team from King of Kings 1, whereby we actually are seeing a very great concept, also game play in this game. That’s why we paid attention to this King of Kings 3 and decided to bought all of the IP rights of this game.

C. Ming Zhao - Susquehanna

Thank you very much.

Operator

(Operator Instructions) Your next question comes from the line of Gerard Sullivan, American Century.

Jerry Sullivan - American Century

Thank you. I wonder if you could just back up a little bit for me and talk about the -- both the change in the game rules that discourage gold farming, and I guess gold farming, by that you mean sort of an experimental play or looking around of some kind, and why you did that and why that is good for the long term. I’m just curious if it doesn’t discourage players to test the game and ultimately become payers. I just wanted some clarification on that. Thank you.

Eric He

Mr. Shi will answer the questions for you.

Yuzhu Shi (Translation)

First of all, it’s actually quite a prominent phenomena in China. There are a lot of gold farming companies and they are pretty pervasive, actually existing in all kinds of games in China. We have actually seen great damage from this group of companies.

Especially in free-to-play type of games, their existence actually generated artificially inflated supply in terms of the gold coin, or the virtual currencies in games. That actually creates the inflation within the game. So it’s actually for the benefit of the balance of the game, or for the player ability of the game to get rid of this group of undesirable target group.

It is actually a common challenge facing almost all the online games in China. We are possibly the most effective company in implementing such a policy, especially in June. We have seen great results in getting rid of or identifying this group of undesirable end users and successfully reduce those numbers. So far, after the policy change or the change of game rules, we have been continuously witnessing the increasing ACU and PCU numbers.

Eric He

Did we answer your question?

Jerry Sullivan - American Century

I’m sure you did, but I just wanted to maybe just for my own clarification -- what does it mean? What does gold farming mean? Obviously it’s an undesirable group. When you say they do damage, do they actually do sabotage damage or is it just taking up space and room that other paying customers could use?

Yuzhu Shi (Translation)

Technically speaking, they don’t cause direct damage to the existing players since they don’t actually get involved in the game play. What those gold farming companies do is essentially they hire a bunch of people, it could be hundreds or even thousands of people, just playing games with interacting with other users to gain virtual currencies in-game and sell those currencies on the other website for real cash, which is RMB.

So in the short term, you may see those people actually generating or creating virtual currency playing the game, while in the long run with this group of people’s presence, they are actually reducing the economic benefit for the game in the long run, since they are not actively the paying players. Secondly, it will create inflation within the game.

According to some unofficial statistics, we are seeing more than 800,000 people engaging in gold farming activities.

Jerry Sullivan - American Century

All right. That’s great. Good answer. Thank you very much.

Eric He

Thanks. Next question, please.

Operator

Your next question comes from the line of George Chu from UBS. Please proceed.

George Chu - UBS

(Translation not available) My question is on costs. On the gross margin for the last quarter, it was down slightly but still very impressive, and you mentioned the small decline is mostly due to spending related to infrastructure. I would just like to know going forward, is that still going to have an impact in 4Q?

Also, in terms of the capitalization of costs for new games, what is the capitalized costs reflected in the cost of service in 4Q? This is my first question.

Eric He

To answer your question, as you mentioned it very well, George, yes it is that we have been very proud to show our gross margin, although that the third quarter actually gross margin dipped a little bit but we think it’s very healthy. Because what we have done is we actually made lots of investments into the servers and also create a lot of the co-location, so we actually incurred a lot of the bandwidth costs. So all of that actually eats into the cost of services. That caused actually a little dip in the gross margin. However, that is really very beneficial for the long-term development of the companies.

I think moving forward in the fourth quarter and the next year, at this moment, it is the company’s policy that we will give revenue guidance but in terms of the gross margin guidance, we are not in a position to make a guidance or prediction at this moment. So for the time being, I cannot very specifically answer the question on the fourth quarter gross margin question, so I have to apologize for that.

For the second part of your question is the capitalized costs and as you know, under U.S. GAAP, when our game becomes profitable, the cost of R&D will be capitalized. So that means until we start to collect money or revenue, that means a commercial launch. So during this period, all the expenditures in terms of related to R&D will be capitalized. So this is under the U.S. GAAP.

For Giant Online, in fact we started capitalization of our R&D developments costs for Giant in January of this year and all the way through this quarter. So during this period, we actually capitalized close to more than $1 million in terms of development costs for Giant Online.

But since from this quarter -- I’m sorry, from the fourth quarter, the capitalization will actually cease and moving forward, all the expenditures related to Giant’s R&D expenses will be actually reported as R&D expenses moving forward.

George Chu - UBS

Right. That’s a great answer. Also, regarding the sales and marketing liaison staff, you have 2,500 at the end of third quarter. Is there a longer term or a mid-term target to how much you grow that force to? And I have one more follow-up question.

Eric He

That actually is related to our sales and marketing. I would like to direct this question to Ms. Liu, our President, and I will do a little translation first.

Wei Liu (Translation)

First of all, as you can tell from the slide, from the second quarter to the third quarter, our liaison offices in our distribution network has increased from 250 to 470, and our liaison personnel has increased from 1,300 to 2,500. That is in preparation for the Giant closed beta testing we are undergoing right now and also the first quarter of Giant's open beta testing.

And more importantly, that is also -- we are actually preparing for the expansion pack release of ZT Online in the fourth quarter. We actually are pretty proud of successfully building up the network as we expect. Now the focus is really about the management and the training of the additional personnel that we have hired to make them an effective member of the overall team.

George Chu - UBS

Thank you. That’s clear. My last question is on the cost of IPO as well as the employee bonus shares. I imagine these costs will be reflected in the 4Q results. Is that correct?

Eric He

I’m sorry, were you saying employment bonus share, meaning the ESOP? Is that what it is?

George Chu - UBS

Yes, that’s what I mean, yes.

Eric He

Yes, in the fourth quarter actually, as you noted, this is the IPO quarter so we will actually, according to U.S. GAAP, we will actually capitalize a lot of expenses into so-called IPO costs. Now we are finalizing this process at this moment and also, upon IPO, we actually issued some of the ESOP, so all of those will affect actually the fourth quarter P&L. So as we are talking right now, it’s affecting the fourth quarter income statements already. However, for the capitalization part of the IPO costs it actually is beneficial in terms of the income statement because all of the expenses will be capitalized and treated as an asset.

George Chu - UBS

That’s great. Okay, that’s all my questions and congratulations for very, very solid numbers. Thank you.

Operator

Your next question comes from the line of Alicia Yapp from Hong Kong.

Alicia Yapp - Citigroup

Good evening and good morning. I joined the call a little bit late so I apologize if my question has already been answered. I have two questions. The first one, in terms of your future pipeline, what type games are you interested to add? Will that stay in the same Chinese martial arts category or would you consider licensing some western style or Korean style games?

And then for your in-house development plans, are you developing any other new games besides the Giant Online and ZT pay to play?

Wei Liu (Translation)

In terms of the company’s strategy, definitely we will be focusing on the self-developed games but at the same time, we actually are very active and also be open about licensing overseas successful games, especially those blockbuster type of games. We are actually open to both casual and also MMORPG type of games.

Our focus will be selecting those complementary type of games and also the games that fit or cater to Chinese players’ preferences. So in terms of the licensing cost, our policy has always been trying to watch out for the costs, not going to overpay for any game.

Alicia Yapp - Citigroup

Thank you. And then my second question is can you give us the range of the average spend on ZT Online? You have a quarterly ARPU of about RMB305 and about RMB102 monthly. What is the highest amount spent by the top spender and will these top spenders continue to spend about the same amount each month? Thank you.

Eric He

Let me clarify; when you say average what? I’m sorry, I didn’t hear very clear, average?

Alicia Yapp - Citigroup

The average amount spent by the users on ZT Online.

Eric He

When you say average, you mean ARPU?

Alicia Yapp - Citigroup

Yes, the range -- for example, the highest amount and the lowest amount, because the ARPU is the average, right? So I would like to know the range from the lowest to the highest.

Yuzhu Shi (Translation)

Generally speaking, I have to say in ZT Online, the beginning yes, there were quite a few users or players that are willing to spend a lot of money in playing this game, but more and more so with the introduction of a lot of features and functions in place, we are seeing the medium spending user group actually taking a much larger percentage in terms of the total overall revenue contribution, and that’s a trend that we expect to continue to see.

Alicia Yapp - Citigroup

I see, and can I have one last question? With your 1.3 million active paying accounts and your ARPU about RMB305, but then your gaming revenue actually came in about $400 million. And your reported online gaming revenue is about $404 million. Is this excluding the $1.2 million licensing revenue? What is the difference? Can you help me understand a little bit?

Eric He

Let me answer the question for you. Maybe I think you are misunderstanding what active paying accounts means. For active paying accounts, if you take active paying accounts 1.3 million times 305, that is not the right equation to get your revenue numbers. It’s not because the definition of active paying accounts means that during third quarter, for that player who actually logged on to our game and also at last paid for it, logged on once and paid for the game, so that is an industry standard definition for active paying accounts. So you cannot use that number to derive revenue. That is not a correct equation to derive revenue.

So if you have the multiple of that result, it will actually lead you to nowhere. So if you compare that -- so I don’t know what is the difference of that, so I just want to clarify on the definition of active paying accounts actually is that the paying player who actually logged on in that particular quarter and at least paid for the game for at least once.

Alicia Yapp - Citigroup

Yes, I understand and because this quarter, you actually disclosed RMB305 is quarterly ARPU, right? But then on your prospectus, this ARPU, is it a monthly ARPU?

Eric He

No, it’s all quarterly. The last quarter was RMB295, the quarter before that was RMB320. It’s all quarterly numbers.

Alicia Yapp - Citigroup

Okay. All right, thank you.

Operator

Your next question comes from the line of [Defan Jian] from City Capital Assets Management. Please proceed.

Defan Jian - City Capital Assets Management

(Translation not available) I have two questions. The first question is about the performance of the ZT PTP online. I just want to know the current ACU. And the second question is about the R&D team and the expansion next year. Thank you.

Yuzhu Shi (Translation)

In terms of the ZT pay-to-play version, we actually had fairly low expectations for the game, since our philosophy is really to focus on the free-to-play model. The purpose of having this pay-to-play version is to serve this niche market that we have identified and that we believe is currently underserved by our company.

So we are very happy to see that we actually -- the performance of the game actually meets our expectations.

In terms of the R&D team, I am very excited about the morale and spirit I am seeing currently, even post IPO. As we speak, the majority of the R&D team people are actually staying back and working continuously in the office.

In terms of R&D capabilities, I think one very important aspect is really to keep the entrepreneurial spirit within the team, to give them the constant motivation so that we can stay competitive.

Defan Jian - City Capital Assets Management

Thank you. (Translation not available)

Yuzhu Shi (Translation)

We are recruiting good, new additional R&D people, so we hopefully by the end of next year, we can double our R&D team.

Eric He

Next question, please.

Operator

Your next question comes from the line of Charles Ho from CAVA Capital. Please proceed.

Charles Ho - CAVA Capital

Thank you for taking my call. Good evening, everybody. My first question is can you give us the operating cash flow and capital expenditures number for the quarter?

Eric He

In terms of operating cash flow, because as you know, our operating cash flow in fact is larger than our net income, because we have decided that on a quarterly basis, we will not disclose our operating cash flow. But I can answer your question in general. Our operating cash flow actually, because of the fact that we have deferred a portion of our revenues, our operating cash flow actually is greater than our net income and -- I’m sorry, the first question was the operating cash flow and --

Charles Ho - CAVA Capital

Capital expenditures.

Eric He

Our CapEx? Is that CapEx you asked? I’m sorry.

Charles Ho - CAVA Capital

CapEx, yes, capital expenditures.

Eric He

Yes, as you know that it is very important for us to provide a state-of-the-art service to the gamers, so we would like to constantly improve our service and that will really rely on our server replacement and our investment in the servers.

So from IPO on, we will actually replace some of the older generation servers that we used to buy two or three years ago. So I think in terms of CapEx, moving forward we’ll be in the range of $30 million to $50 million on an annual basis -- to purchase the servers and storage devices.

Charles Ho - CAVA Capital

Thank you. My second question is since you already have like RMB6 billion of cash, let me ask you, all your IPO proceeds, have you already converted them into RMB already, or they are still deposited in U.S. dollars? That’s the first part of my question.

The second part of the question is with so much cash, how do you plan to spend it?

Eric He

The first question is the money that we have now, how do we allocate the money and the second part is how do we spend the money. I think I will direct the second part to our President, Ms. Liu.

For the first part of the question, let me address your question at this moment. Because as you know, the IPO proceeds that we raised, we actually parked the money right now off-shore in the U.S., in U.S. accounts. It’s not been remitted [inaudible]. I think in the foreseeable future, we don’t have a plan to move that money on-shore into China. The reason is that currently, as I mentioned, our operating cash flow has been very strong. We have about RMB1.2 billion on hand on-shore, that is in RMB accounts. So we actually have RMB1.2 billion on hand and the proceeds that we raised from the IPO off-shore.

So currently, I think we are keeping a very good balance in terms of RMB exposure and U.S. dollars exposure.

For the second part of your question, I will direct that to Ms. Liu.

Wei Liu

(Translation not available)

Charles Ho - CAVA Capital

Thank you. Eric, I want to follow-up on your cash allocation, or whatever it’s called. Do you realize that the U.S. dollar is on a depreciation trend? To me, it doesn’t make sense that you keep a huge part of the money in U.S. dollars in a U.S. account, because it’s depreciating.

Eric He

That’s a great question, Charles. Let me tell you this; we are very conscious about what you worry. In fact, we will -- first of all, we will put that money into cash equivalent accounts, so we will not actually put that into so-called investment accounts.

In order to do that, we will actually try to ask the bank to help us to hedge the risk against appreciation of RMB because our reporting currency actually is RMB, and so that is already in the way. But I have to tell you that we will not do any risky investments. We will put that into a very liquid account and to hedge the risk or exposure of appreciation of RMB.

Charles Ho - CAVA Capital

Can you elaborate a little bit on the specific hedging technique that can be used?

Eric He

At this point, I can only tell you that we will not deal with future options and that sort of thing. We will not. We will not touch that kind of thing but only to tell you that we will put it into a cash and cash equivalent account in a very safe deposit. So that’s all I can report to you because we are in the process of reviewing all the options at this moment.

Charles Ho - CAVA Capital

That’s good, but actually I just want to say again that I think the U.S. dollar, it looks like it’s on secular depreciation trend, so I would like the company to have a way to preserve its worth in this huge amount of money.

Eric He

Your viewpoint is fully appreciated by ours, and so yes, we understand exactly what you mean. We will be very cautious and conscious on this viewpoint.

Charles Ho - CAVA Capital

Thank you. Then my next question is a follow-up on your capping basically the amount of money that players can pay to RMB15 to RMB30 per week, right, depending on the experience level on your Giant Online. And you have explained that [inaudible], you expected to have good revenue because you expected to have much more paying customers or players. So can you give me the reason why -- why is it that you can expect Giant Online to have much more paying players compared to ZT Online?

Eric He

I would like to direct this question to Ms. Liu. I will translate that; if I understand this question correctly, it’s like this. Okay, Mr. Shi will answer your question.

Yuzhu Shi (Translation)

First of all, in China’s online gaming industry, we are actually seeing great change in terms of the landscape or the viewpoint, the school of thought, so we need to adapt our thinking.

One thing we observed is Korean developers, their games development capabilities are improving so the games coming to China actually are having or exhibiting better quality. However, in terms of users’ adoption, we are actually seeing a decreasing trend.

We actually did a study behind the users’ preference change and their school of thought and their viewpoints towards online games and that is the fundamental or the cornerstone of how we come up with Giant Online. From our initial closed beta testing results, we actually are expecting the revenue from Giant Online will be at least no less than the ZT Online game. This is a direct result of the change in terms of users’ spending behavior and also their playing behavior.

For Giant, we actually see, as you have pointed out, the percentage of paying players increase and also the willingness to spend on behalf of their friends is also increasing.

Eric He

Okay, next question. No more?

Operator

At this time, I am showing you have no more questions. I would like to now turn the call back over to Mr. Eric He. Please proceed, sir.

Eric He

Thank you again for joining us today and we look forward to updating you on our progress in the near future. Thank you, everyone.

Operator

Thank you for your participation in today’s conference. This concludes the presentation and you may now disconnect. Have a good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!
Source: Giant Interactive Q3 2007 Earnings Call Transcript
This Transcript
All Transcripts